Using Moving Averages as Dynamic Support and Resistance
One use for moving averages is as dynamic support and resistance levels. We cal them dynamic because, unlike traditional support and resistance levels which are horizontal, they are constantly changing as a result of recent price action.
In fact, it is quite common for trading strategies to be at least partly built around using moving averages as key support or resistance areas, with traders buying when price falls to test the moving average and selling when price rises to test the moving average.
In the chart above, we can see that pretty much every time the price touched the moving average, it bounced back. This held true even when the trend reversed.
However, you will also notice that it didn’t do so perfectly every time. That’s because moving averages should be considered as ‘areas’ rather than strict boundaries, just like normal support and resistance lines.
Sometimes, the price will go a bit beyond the line before bouncing back. That’s why it can pay to use two moving averages, as we have done in the chart above. Using two, you can decide to buy or sell only when the price is in the middle of the two moving averages – a space that can be considered a support or resistance ‘zone’.
So, by using MAs of differing time periods, we can be a little more exact about what we mean by the ‘zone’ of support of resistance, rather than merely guessing at it. Of course, there is still a degree of guesswork involved, certainly in terms of the settings for the moving averages, but you can refine this over time using historical data to discover the most useful periods for the pair you are trading.
Breaking through Dynamic Support and Resistance
As we saw in the chart above, the price doesn’t always bounce back from these dynamic support and resistance areas. Sometimes, it goes straight through it – just like with a traditional support or resistance level. When this happens, it can often signify a breakout, and a reversal of the trend.
So, as we can see from the above chart, the moving averages held as a strong support level until the price broke through it – after which, the trend reversed, and they turned into strong resistance levels.
Perhaps the best thing about using moving averages as support and resistance levels is that they are always changing. This means that you don’t have to keep looking back over historical price charts to identify potential areas of support and resistance – you can just leave them on your chart.
As with Fibonacci lines, the fact that a lot of other traders will be using moving averages in the same way means that they can become a self-fulfilling prophecy, making them a more effective predictor than might otherwise be the case. Of course, not everyone will be using the same periods, so it’s not an exact science, but through experimentation you can find the ones that it looks like most of the market will be using.
As we have seen, moving averages are one of the easiest indicators to use. The only real difficulty is in deciding which ones to use. To this end, here’s a quick recap of the points we have covered so far:
- There are several types of moving average, but the most common types are Simple Moving Average (SMA) and Exponential Moving Average (EMA)
- Simple moving averages can give the clearest indications of trends, but can also be thrown off by spikes.
- Exponential moving averages tend to be bumpier, but are in some ways more accurate because they emphasise recent price action.
- In general, it is more important to know what traders are doing now, rather than last week or last month.
- The longer the period of a moving average, the smoother it will be
- Exponential moving averages are better for spotting trends quickly, but they are more susceptible to fake outs.
- Smooth moving average respond slower to trend reversals, and can therefore cause you to miss good opportunites, but they are less susceptible to spikes and fake outs.
- Moving averages can help you to define a trend, determine an entry point, and see when the trend is about to end.
- Moving averages can be used as dynamic support and resistance levels.
- By plotting more than one moving average, you can see long term and short term movement side by side.
More articles in this series:
A forex trader’s guide to moving averages: Part 1
A forex trader’s guide to moving averages: Part 2